The lecture I gave at Harvard Business School in October of 2006 was well received (according to my wife who was in attendance). I was asked a number of very technical questions, which is what you would expect when you give a lecture to students obtaining their masters’ degrees at Harvard. One of the questions revolved around taking cash out of the transaction. I gave my answer and then thought that would be a great article for a CPA magazine. I wrote an article which was in fact published in the CPA Journal. I should apologize up front, the article and this blog is a little more technical than my normal blog content, but remember, it was printed in a technical periodical.
"Taking Cash Out of a 1031 Exchange without Receiving Boot: Tricky but Not Impossible"
By: Stephen A. Wayner, Esq., CES
One of the central tenets of a delayed 1031 exchange through a Qualified Intermediary is that the taxpayer cannot have access to the proceeds from the sale of the relinquished property, except in the form of qualified replacement property transferred via the Qualified Intermediary. This restriction is consistent with the concept that an “exchange” of real estate has occurred, rather than a taxable sale of the relinquished property followed by a purchase of new property by the taxpayer. Nevertheless, there are circumstances where the taxpayer desires access to some of the cash equity in his real property, whether to purchase more investment property, or for any other purpose. Fortunately, with careful planning, it is often possible to tap into the underlying value of the exchange property, either by refinancing (in the form of additional borrowing) the relinquished property prior to the exchange, or by borrowing against the replacement property after the exchange has been completed.
Refinancing with a third-party lender was once considered by the IRS to be equivalent to cashing out of a property, when such refinancing was determined to be “in anticipation of exchange.” The idea was that borrowing against one’s property just before it is to be exchanged, is in effect no different from receiving a partial distribution of the sales proceeds from the relinquished property. In fact, the IRS went so far as to propose an amendment to the Regulations in 1991, which would have expressly made debt incurred on exchange property in anticipation of the exchange equivalent to taxable boot, but the proposed amendment was scratched because it would have added too much uncertainty into the exchange process. As time has passed since the IRS’s 1991 attempt to adopt a blanket rule against refinancing exchange property, the Courts have been much more liberal in construing cases where taxpayers borrow funds either from the replacement property following an exchange, or from the relinquished property prior to an exchange.
The federal cases and IRS rulings on refinancing immediately before or after a 1031 exchange show a clear trend. In those cases where the taxpayer has bona fide, non-tax reasons to justify the borrowings, the taxpayer generally prevails. In cases where there the borrowings are tax-motivated, and lack substantial economic effect, the amounts borrowed were considered taxable as if they were a distribution of the sales proceeds to the taxpayer. It seems that the following factors will be considered in whether the new loans involved will be respected when used to equalize the exchange liabilities:
1. Independent Economic Significance and Valid Business Purposes. The primary factor in the decision is whether the financing has independent financial significance, and whether there is a valid business purpose to the financing. Valid business reasons include changes in interest rates, loan covenants, needs to obtain cash for documented expansion plans, or changes in the taxpayer’s financial position that would encourage an exchange. In Garcia v. Commissioner, 80 T.C. 491 (1983) the taxpayer desired to “even up” the equity in two properties by placing loans on the relinquished property prior to the exchange, thus permitting the mortgage netting rules under 1031 to ensure full tax deferral. The Tax Court ruled (and the IRS acquiesced), that gaining such beneficial tax treatment for the exchange, constituted a valid business purpose for the re-financing; hence the borrowing was justifiably not taxable.
2. Timing. The closer to the exchange date, the more likely the increased debt will not be approved by the IRS. Ideally, the financing should be initiated prior to negotiations for the exchange. In Fredericks v. Comr., 534T.C. Memo 1994-27, the taxpayer's financing of the relinquished properties immediately before the exchange did not constitute boot, where the taxpayer's reasons for financing were unrelated to the exchange. The taxpayer's uncontroverted testimony was that he began attempts to secure long-term financing long prior to the date on which he entered into the agreement to exchange the relinquished property.
3. Identity of Lender. Loans from related parties, or even from the buyer of the relinquished property, are considered by the IRS as inherently suspicious and are more likely to be challenged as lacking substantial economic effect. This was demonstrated in Long v. Commissioner, 77 T.C. 1045 (1981), when the IRS disregarded the re-allocation of liabilities between the partners of a partnership immediately before an attempted 1031 exchange (partners in a partnership are considered related parties).
The cases also make it clear that re-financings that occur after the exchange are much less likely to be challenged than are re-financings that occur immediately prior to a 1031 exchange. If a taxpayer desires to take cash out of an exchange, the safest way to accomplish such borrowings without triggering IRS scrutiny is to document valid business reasons for the loan. Generally, changes in interest rates, a withdrawal deadline imposed by the lender, the desirability to lock-in a rate of interest, or plans to expand ones business constitute valid non-tax motivated reasons to re-finance.
To summarize, while a taxpayer cannot withdraw cash from the proceeds of the sale of his or her relinquished property without triggering taxable gain, it may be possible to take funds out of a 1031 exchange by borrowing against one of the properties in the exchange, if the taxpayer is careful to document a valid business purpose for the loan, and if the taxpayer uses an unrelated third party lender. In general, the longer the taxpayer waits to refinance the replacement property, the lower the risk that the transaction will be deemed taxable.
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